ACT301 Week 6 Tutorial

Chapter 7: Positive Accounting Theory

7.7 An agency relationship occurs when decision-making authority is delegated

from one party (the principal) to another party (the agent). Jensen and Meckling
(1976, p.308) define the agency relationship as:

a contract under which one or more (principals) engage another person (the
agent) to perform some service on their behalf which involves delegating
some decision-making authority to the agent

From the Agency Theory perspective, the ‘contract’ itself does not need to be
written. Because it is assumed that all individuals will act in their own self-
interest, there will be costs (agency costs) associated with appointing agents to
make decisions on behalf of the principals. Agency costs can be defined as costs
that arise as a result of the agency relationship and relate to the costs that arise as
a result of the process of delegating decision making to others.

Pursuant to Agency Theory it is argued that various contractual arrangements

will be put in place to minimise anticipated agency costs and hence to increase
the value of the organisation. For example, to minimise the agency costs relating
to appointing a manager, contractual arrangements might be put in place to
provide the manager with a share of profits. That way, the manager will be
motivated to make decisions that lead to an increase in profits and, all things
being equal, this will also be in the interests of the owners.

An organisation is considered to represent a nexus of contracts between many

self-interested individuals and the reason for having the various contracts is to
reduce the agency costs that the organisation might otherwise encounter and
consequently to maximise the expected value of the organisation.

7.8 Political costs are those costs that particular groups external to the firm may be
able to impose on the firm as a result of various actions. For example, the costs
associated with the community lobbying the government to decrease the subsidy
support for an organisation, the costs associated with labour unions taking

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 actions to increase the wages of their members or the costs associated with
consumer boycotts associated with the firm’s products.

The political cost hypothesis predicts that those organisations under political
scrutiny (usually assumed to be larger firms) will undertake actions to minimise
the possibility of adverse cash flows associated with the scrutiny. For example,
if a company is being scrutinised in a particular period because of its perceived
monopoly powers and those external parties undertaking the scrutiny claim that
these monopoly powers enable it to generate excessive profits, then in such
periods the entity may elect to adopt accounting methods which reduce its
reported profits, and hence, its susceptibility to actions to reduce the wealth of
the organisation (perhaps, in the form of increased taxes). Watts and
Zimmerman provide the following explanation of the political cost hypothesis:

The political cost hypothesis predicts that large firms rather than small firms
are more likely to use accounting choices that reduce reported profits. Size
is a proxy variable for political attention. Underlying this hypothesis is the
assumption that it is costly for individuals to become informed about
whether accounting profits really represent monopoly profits and to
‘contract’ with others in the political process to enact laws and regulations
that enhance their welfare. Thus rational individuals are less than fully
informed. The political process is no different from the market process in
that respect. Given the cost of information and monitoring, managers have
incentive to exercise discretion over accounting profits and the parties in the
political process settle for a rational amount of ex post opportunism (1990,
p.139)

As reflected in the above quote, the political cost hypothesis assumes that various
parties will simply react to the quantum of reported profits and will not necessarily
focus on which accounting methods were used to generate these profits.

7.14 Pursuant to the political cost hypothesis there is a view that disclosing high
profits can lead to costly political scrutiny. To reduce this scrutiny, managers
can elect to apply accounting methods that lead to a reduction in reported profits.
That is, rather than actually changing their operations, or increasing the

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 payments to particular groups, the managers simply change the accounting
practices they use.

Because political processes can involve many parties, the likelihood that
individual actors can influence particular outcomes is low. As such, if
politicians, labour delegates or other officials use reported profits as a
justification for particular actions then the constituents will have little incentive
to unravel the accounting numbers used to support the politicians’ or officials’
arguments. That is, the constituents will elect to be ‘rationally uninformed’.
Being ‘rationally uninformed’ implies that it is actually efficient (rational) not to
spend too much time and effort to be aware of the basis of political decisions if
the individual (perhaps as a voter) has a limited expectation of affecting the
outcome of a decision. Maintaining the assumption of self-interest, politicians
and other representatives are anticipated to know that constituents will not spend
too much time investigating the background to their various decisions and hence
they can justify decisions simply on the basis of reported profits. Managers are
also assumed to be aware of this and as a result believe that benefits will follow
from simply changing accounting methods.

7.15 The policy decisions made by members of the IASB should give some
consideration to the insights provided by PAT. PAT provides numerous insights
into what motivates managers to report certain information, to choose certain
accounting methods, and so forth. It also provides insights into why management
might not favour particular accounting methods. For organisations such as the
IASB it is useful, and perhaps imperative, that they understand some of the
factors that might motivate corporate managers, and other interested parties, to
lobby for or against particular accounting methods or practices. PAT provides
some such insights. By understanding the motivations that might be motivating
corporate managers to make particular submissions, accounting standard-setters,
such as the IASB, are better placed to understand and evaluate the submissions
being made by various stakeholder groups.

Further, PAT can also provide insights into the implications that might follow
should an accounting standard be released (for example, implications for

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efficient contracting), and this is useful to consider before any accounting
standard is ultimately mandated.